In the FCIC’s inaugural public
hearing last week, there seemed to be widespread
agreement among Commissioners and witnesses about the dangers posed by the unregulated
over-the-counter (OTC) derivatives market, and the need to move as much of this
trading as possible to centralized clearinghouses and exchanges. But as Federal
Deposit Insurance Corporation (FDIC) Chair Sheila Bair pointed out, it’s
ultimately up to Congress to pass the necessary reforms: “I think this should
be a very high priority for Congress. And there’s only so much regulators can
do until that legislation is enacted.”

The FCIC—with its $8
million budget, its authority
to subpoena witnesses and documents, and the collective wisdom and
experience of its 10 Commissioners, including former Commodities Futures
Trading Commission (CFTC) Chair Brooksley
Born—has the potential to thoroughly investigate the relationship between
OTC derivatives and the financial meltdown, and to formulate meaningful
recommendations for regulating this market. Unfortunately, the FCIC’s final
report won’t be released until December 2010, long after the Senate is
scheduled to pass its version of legislation to overhaul the nation’s financial
regulatory regime.

Nonetheless, we hope the Senate pays close attention to the
advice of the FCIC Commissioners, witnesses, and other experts who are sounding
the alarm about the potential loopholes in Congress’s proposal to regulate this
market.

The End-User Exemption — A Potential Impediment to Reform

In a speech
before the Atlantic Council last week, CFTC Chairman Gary Gensler explained
how the big Wall Street banks could stand to benefit from one such loophole.
He’s referring to the so-called “end-user exemption,” which is basically Congress’s
attempt to recognize a distinction between 1) the end-users: non-financial sector companies,
municipalities, and non-profits that use derivatives as a standard business
practice to hedge against risk (e.g., an airline protecting itself against an
unexpected rise in fuel prices), and 2) the big Wall Street swap dealers that
often use derivatives such as credit default swaps as a means of high-risk
speculation. Many end-users are concerned about having to comply with new
requirements for derivative counterparties to post margin and collateral for
their trades through central clearinghouses.

The Bank for International
Settlements publishes data on counterparties in several OTC markets. As of June
2009, 34% of OTC contracts were between reporting dealers, 56% were between dealers
and other financial institutions, and the remaining 10% involved dealers and
nonfinancial entities.

Thus, nearly two-thirds of OTC derivatives involve an end user. If all
end users are exempted from the requirement that OTC swaps be cleared, the
market structure problems raised by AIG still remain. [Emphasis POGO’s]

And as Chairman Gensler explained, it’s actually the big
Wall Street dealers, not the end-users, that benefit most from keeping OTC
derivative trades in the dark:

When a Wall Street bank enters into
a bilateral derivative transaction with a customer, the bank knows how much its
last customer paid for similar transactions, but that information is not
generally made available to other customers or the public. The bank benefits
from internalizing this information....

As a driver can best decide which
gas to buy based on public prices posted at each gas station, corporations
could better decide how to manage the risks associated with their business if
they knew how much others were paying to manage similar risks. As such, it is
the Wall Street banks that benefit from the so-called “end-user exemption” from
transparency, not the businesses that use derivatives.

Eventually, House Financial Services Committee Chairman
Barney Frank (D-MA) scaled
back the exemption in the House’s financial regulatory reform bill. But all
eyes are now on the Senate, where Banking Committee Chairman Chris Dodd (D-CT)
is under pressure to include
a similar exemption.

And Still Other Loopholes Remain

And this
isn’t the only potential loophole that could make its way into the Senate’s
OTC derivatives bill. Last month, POGO
wrote to Congress raising concerns about a provision in the House’s bill
that would allow OTC derivatives trading to occur on a new platform called an “Alternative
Swap Execution Facility.”

The best way to achieve the transparency that Chairman
Gensler and others are calling for is to move OTC derivatives trading to well-regulated
exchanges, which are required
under the existing law to “make public daily information on settlement
prices, volume, open interest, and opening and closing ranges for actively
traded contracts on the contract market.”

But under the House’s definition of an Alternative Swap
Execution Facility, there’s no requirement for trading to happen under a regulated
exchange; in fact, the Facility can simply be any “person or entity that
facilitates the execution or trading of swaps....including any electronic trade
execution or voice brokerage facility” (i.e., over the telephone). It would
then be up to the regulators to decide how much information to disclose about
these transactions. The bill even appears to instruct the regulators to err on
the side of secrecy: “The Commission shall evaluate the impact of public
disclosure on market liquidity in the relevant market, and shall seek to avoid
public disclosure of information in a manner that would significantly reduce
market liquidity.”

Once again, it’s the big Wall Street dealers that are
fighting hard to maintain this loophole, since greater price disclosure will
reduce their profits. One analyst has estimated that JP Morgan alone stands
to lose some $3 billion if derivative trades are moved to exchanges. As Stanford
finance professor Darrell Duffie put
it to The Wall Street Journal, “exchanges
are anathema to the dealers.”

But rather than kowtowing to the big banks on this issue, we
hope the Senate heeds the advice of the officials and experts who are trying to
prevent another financial crisis. Again, the best way to inject a much-needed
dose of transparency into the OTC derivatives market is to close the loopholes
in the House’s bill and move as much trading as possible onto well-regulated
clearinghouses and exchanges.

To learn more about this issue, be sure to check out POGO’s
podcast on derivatives reform.